Get Briefed: Jeremy Grantham

Jeremy Grantham is chairman and co-founder of the investment firm Grantham, Mayo, Van Otterloo Company (GMO). Based in Boston, the firm oversees $100 billion for clients. Currently, Grantham is an active member of GMOs asset allocation division. Prior to GMOs founding in 1977, Grantham was co-founder of Batterymarch Financial Management in 1969. There, Grantham recommended commercial indexing in 1971, one of several claims to being first. He began his investment career as an economist with
Royal Dutch Shell
. Grantham earned his undergraduate degree from the University of Sheffield (U.K.) and an M.B.A. from Harvard Business School.

Debriefing Grantham

Interviewed by David Serchuk

"I think great thinkers are not drawn to finance." -Jeremy Grantham

Forbes.com: What is one misplaced assumption in business today?

Jeremy Grantham: I think we collectively missed that global profit margins were extraordinarily high and would come down this year and next year and overrun normal, as they always do. And that would pose a real stress on the stock market and on corporate fundamentals.

What is the greatest financial lesson you've ever learned?

I would say that financial markets are very inefficient, and capable of extremes of being completely dysfunctional. I learned that in 1974, '82, '87, '2000 and definitely not excluding 2008.

Why do you keep having to learn it?

It's a question of how much you believe it. I take 2008 as confirmation, not learning. I really had learned it by 2000.

Who is the greatest financial mind working today?

I do think we have a problem here. There is a gap in this area. I would have said, in the old days, Franco Modigliani, but he died a few years ago. In the pretty good character realm, there is Robert Shiller, Andrew Smithers in London, Mark Faber in Timbuktu. That's a list of good people. But for my money lacking the great financial minds.

I think great thinkers are not drawn to finance. There are higher and better uses [for them]. I think Modigliani was a broad-based economist drawn into finance, but it was far from all he did. He was an economist. I am differentiating between economics, the real economy, and the financial world of stock prices and bank debt.

I'm not saying it [finance] deserves the great brains, I'm just saying it doesn't get them. I consider most of the talent in the financial world to be suboptimal. It could be better placed earning its living in the real world.

What is your bold prediction for the future?

Keying off the word "bold," my prediction is that China will be a substantial disappointment. The reason I say "keying off" is that this is far from being a certain prediction. But I have a strong hunch China will disappoint, and maybe been bitterly disappoint.

That's the nature of the hunch, I look at everything and my stomach tells me they've been extraordinaly lucky in the last 15 years. It's hard to separate good luck from talent. I have a suspicion that a lot of what other people see as skill was good luck. And that they have a difficult job, and under this stress their modest talent will be revealed. The modesty of their talent.

What are some ways they got lucky?

They got lucky that the U.S. decided to run a huge trade deficit when they needed to run a huge surplus for political reasons. And it balanced out, as long as we ran an equal deficit. They were presented with the strongest global economy in history in which to sell their cheaper products.

You had mentioned that the Chinese are new to capitalism, so their bench is not very deep.

Are they really so much better that they can handle an economy growing at four times the speed of the U.S. with a lack of experience? It doesn't compute, but we will find out.

What is one question you would ask Alan Greenspan?

What did you do to get the job? Because nothing in your record seems to justify it.

Have you ever talked to him?

No, and I'm happy to leave it that way.

What would you ask Ben Bernanke?

How did you possibly miss the housing bubble? How could you say at the peak of this three-Sigma event--a one in 1,000 year event at the top of 2006--how could you say the U.S. housing market merely reflects a strong U.S. economy? Surrounded as you are by all this statistical help, and with your experience with the Great Depression, how could you miss it? I simply don't get it.

What sort of housing price declines do you see coming in Britain and the U.S.?

In the U.S., we see a modest 5% decline to fair value. So that has really come down, as we said it would, a year ago and two years ago. We said it would come down to trend. It's only 5% away. But bubbles that are two- to three-Sigma bubbles have always overcorrected. There is no precedent to how much it will overcorrect. Using the analogy of other bubbles, we should count on an incremental 10% overcorrection and hope that it isn't worse. The history of other bubbles show the correction could be much worse, but you can count on a 10% overcorrection, or 15% in total.

What about Britain?

Ugh [laughs]. If it happened quickly, it would be entitled to decline by a solid 35%, plus an overrun. So anything up to a 50% decline from the peak. If if happens slowly and gives time for family income to climb that will mitigate it. We usually state that as a 50% decline immediately, or 12 years marking time. My guess it will happen pretty darn quickly. It will be unlikely that they don't drop 40% from the peak over two to three years, starting six to nine months ago. They do a mean bubble.

How cheap are global equities now?

They are decently cheaper than the U.S., particularly as of this afternoon. So you should get an extra 15% for Japan, maybe an extra 20%, over seven years, vs. the U.S. and in emerging markets.

So should people get diversified into international stocks?

Oh, yes. The U.S. may be relatively blue chip in a crunch, but they are priced at a decent premium to the rest of the world's equities, once again.

Please explain your theory of right- and left-brained CEOs, and how we keep choosing the wrong ones at the wrong times to lead American firms.

I think what I call the Great American Executive is always going to be good at dealing with crises after they've occurred. Always moving fast, focused, short-term-oriented at making decisions. Usually they're short-term-oriented decisions. And he has a lot going for him or her. The weakness is that special outlier events are never, ever seen coming. They're just not the kind of people that think along those lines. That's a more creative, right-brained activity.

What I refer to as "the feet on the table with a coffee cup," bullshitting about the 1930s and 1970s--[that type of person] could happen. And you take outlier events very seriously. They are informed by history and know that strange things shock the world at regular intervals. And your impatient, decisive short-term CEO is not tuned in to get that. Nor is he tuned in to listen to anyone in the organization saying they should watch their tails. Also, CEOs are very aware of career risk. If they're too conservative, they are likely to be replaced by a more gun-slinging type from Credit Suisse, as I like to say.

Do the boards share same characteristics of the CEOs?

Yes, and it's a shame. They are made up of CEO buddies and bootlickers. In theory, it's an opportunity to put in more philosophical, right-brained input in a way that the CEO would have to listen--not in the way he can dismiss his in-house think-tank types. You can have members of the board lean on him, and he might listen, or she might listen. But by having similar CEO types and friends dominate, you're not going to get that help. It's a missed opportunity.

What kind of brain do you have?

I think I'm right-brained, incapable of managing my way out of a brown paper bag.

You seem to be doing well so far.

If only you knew. But the right brain is better suited for long-term investing than short-term management.

Ten years ago, you predicted the S&P 500 would be down 1.1%, and you were almost exactly right. What is your prediction for 10 years out?

Now I do seven years. It's as of today, 7.2% real returns per year. That's not bad, but it's pretty ordinarily cheap. It's not extravagantly cheap. A couple of more days like today and we'll be passing through normal. That's annualized real returns, including dividends. But that's a whole lot better than -1.1%.

It is just straightforward arithmetic. We generate the number on assumption that P/E ratios and profit margins will return to normal. It's the same way we did it 10 years ago. It's proven to be a very durable and fairly accurate methodology.

Forbes on Grantham

OutFront

What Are They Waiting For?

Bernard Condon, James M. Clash and Zack O'Malley Greenburg

11.17.08, 12:00 AM ET

One reason stocks are crashing: Investors are sitting on wads of cash.

Famed investor Jeremy Grantham says he hasn't seen stocks this enticing since the 1987 crash. The value mavens at the Delafield Fund note that even by their tightwad standards shares are "extremely attractive." Robert Rodriguez, whose FPA Capital Fund has been piling up cash for five years, is finally getting excited about buying again.

Yet, cheap as these managers think the market has gotten, they're convinced it's going to get considerably cheaper before hitting bottom. So they're hoarding cash, biding their time and waiting for specific buy signs: a drop in the S&P 500 to a certain level, a spike in the Dow's dividend yield or a drop in bank stocks' price-to-book ratios near to where they bottomed in previous financial panics.

"We're going to have one great [buying] opportunity, but we're not there yet," says 87-year-old money manager Charles Allmon, whose Charles Allmon Trust (which he sold to Liberty Financial in 1996) was the only mutual fund to rise on Black Monday in October 1987.

Not just pros are holding off. Federal Reserve statisticians calculate that U.S. households, as of June, were sitting on $7.8 trillion in Treasury securities, bank deposits and money market accounts. Some of these bears are people who have never owned stocks, some are investors who dipped their toes in earlier this year and regretted it, and some are long-term bulls waiting for one more shoe to drop before they make a move.

FPA's Rodriguez, with 38% of his $1 billion fund in cash, thinks U.S. consumers have run into a brick wall when it comes to living on borrowed money. As a new frugality takes hold, and consumers hoard their incomes, long-term GDP growth will fall by a third, from 3% to 2% a year, he figures. As it does, corporate profits could drop by a third as well, to 7% of revenues.

"We're facing a long, arduous journey," Rodriguez says.

Not all the smart money is so negative. On Oct. 17 Warren Buffett, the man who has gotten richer than any other divining when to buy and sell stocks, penned an opinion piece in The New York Times titled "Buy American. I am." Buffett emphasized that calling a bottom is impossible but noted that "If you wait for the robins, spring will be over."

Former
Morgan Stanley
strategist Barton Biggs, who once graced the cover of FORBES in a bear suit, joined the buy-now crowd in October as well, declaring: "We're at very, very cheap levels."

That sentiment, of course, has left a lot of wealthy investors a lot less wealthy as they bought during this year's 40% fall in the S&P 500. That quick decline qualifies as the steepest (if not yet the deepest) since 1931. Billionaire Joseph Lewis lost nearly the entire $1 billion he sank into Bear Stearns last summer. Forbes 400 member David Bonderman, whose private equity firm, TPG (formerly Texas Pacific Group), made a fortune buying busted companies in the 1990s, saw its $2 billion investment in
Washington Mutual
vaporized when regulators orchestrated a shotgun wedding with
JPMorgan Chase
in September.

The latest victim: a group led by New York hedge fund Corsair Capital that bought half of ailing
National City Bank
for $7 billion earlier this year. When National City's problems got worse, the investors were forced to take a 60% haircut and agree to a sale of the entire business to PNC Financial Services for $5.2 billion in late October.

What bells have to ring, or alarms go off, before the remaining sideliners think it's safe to get back in the market?

David Ellison manages FBR's small- and large-cap financial funds, with combined assets of $172 million. He made a killing in the late 1980s buying bank stocks for an average of 45% of book value. He got some for as little as 25% of book.

He's now waiting to buy bank stocks for half of book value (PNC just paid 30% of book for National City). Most banks aren't there yet. The KBW Bank Index is trading at 0.9 times book. So Ellison, who was 5% in cash three years ago, has ratcheted up to 50% cash. He's increasing that, too, by selling banks like
Wells Fargo
and
UBS
, which are trading at two to three times book value.

"If I buy a bank stock today, I want to see it able to go up three- to fourfold to offset the fact that it might go down another 30% to 50%."

Value investor Grantham, the 70-year-old chairman of GMO, manages $100 billion and declared himself "officially scared" in July. He says that at 877 recently, the S&P 500 is trading for 10% less than its fair value. That's the first time it has been below Grantham's fair value estimate since 1994. Blue chips
Coca-Cola
and
Johnson & Johnson
look like steals at 20% discounts. Yet Grantham is buying only in a "creepy, slow" way.

He says more bad earnings news will probably cause the market to overshoot further on the downside. His odds that the S&P will lose another one-third of its value and dip down to 600: one in three. Grantham has half of his portfolios in bonds and cash.

"This one [bear market] has so many complications," he says. "Housing's still going down; pressure is still on the financial system; money funds can't deliver; illiquidity is everywhere."

Vincent Sellecchia, comanager of the $578 million Delafield Fund, returned 13.2% annually over ten years, beating the S&P 500 by over ten percentage points a year. He went 100% into equities after the 1987 crash. But now Delafield has 18% in cash, up from 9% last December.

What would make him sink it into stocks? Not fair value. At the moment he doesn't think the market gives a whit about it. Instead, Sellecchia is waiting until what he sees as "indiscriminate" selling subsides, and he feels he's not wagering his investors' money in a futile battle against the market's downward momentum.

Allmon, the hero of the 1987 crash, is something of a permabear, with a 75% cash hoard for the past decade. "People used to say, 'You're off your rocker, Allmon,'" he says. "Now I'm having the last laugh." Allmon predicts the S&P 500 will fall another 50% or so, to 450.

Allmon, who runs the newsletter, "Growth Stock Outlook," gives this advice: Jump into stocks after the dividend yield on the Dow returns to its 20th-century average of 7.1%, up from 3.9% today.

"This bear market has a long way to go," Allmon says.

That's not what the millions of people hoping to save their homes and restore their retirement accounts want to hear, but it might be the case.

Equity Mutual Funds

Markets Continue Drop; More Blood Ahead

James M. Clash 10.25.08, 12:00 PM ET

This week the S&P 500 lost another 6.8%, closing at 877, and panicked shareholders responded in predictable fashion: They yanked more money--another $6.5 billion--from equity mutual funds. As of Oct. 22, $63 billion had exited stock funds for the month so far, an all-time monthly record, bringing year-to-date redemptions to $181 billion, also a record, according to TrimTabs Investment Research.

With the S&P off a mind-boggling 40.3% for the year now, some money managers are screaming that this is a once-in-a-lifetime opportunity. They see panic redemptions by retail investors as a major buy signal.

Not so fast, say others. Jeremy Grantham, chairman of Grantham, Mayo, Van Otterloo (GMO) in Boston, oversees $100 billion for clients. Over the last few weeks, as the market has cratered, he has moved his portfolios from extremely bearish (38% equities, 62% fixed income) to just bearish (a 50-50 ratio). "We are creepy-slow capital buyers at these levels," Grantham admits grudgingly.

Areas where he is nibbling include emerging markets and parts of the S&P 500. While the S&P as a whole is only 10% below Grantham's fair market value estimate of 975, it's the blue chip group--the likes of Coca Cola, Johnson & Johnson and
Procter & Gamble
--where he's most interested. He says this category in particular is more like 20% off of fair market value.

Grantham, 70, has been at this game a long time. The well-respected value manager says today's market is unlike any he's ever seen. In the 1973-'74 bear market, for example, it was a steady grinding down of stocks (eventually off 49%) with a simple oil squeeze.

"But this one has so many complications," he continues. "Housing's still going down, pressure is still on the financial system, money funds can't deliver, illiquidity is everywhere and managers have to sell to meet redemptions or to pay the rent. And no one really knows how it will all work out."

Grantham believes it is likely the market will break its recent lows as the world is faced with "a meat grinder of global earnings disappointments" in 2009. His projections are downright scary: He says there's a 70% chance the S&P will sink to 800, and a 30% chance it will touch 600.

David Ellison manages both the FBR Small Cap Financial and FBR Large Cap Financial portfolios. Like Grantham, he has a 50% cash stake in his funds now, up from just 5% a few years ago. But instead of buying at these depressed levels, he is selling selectively--banks trading at two to three times book value. He is waiting until--get this--he can buy them back at 50% of book value. He cites as an example National City, which sold today to PNC at just such a valuation.

Like Grantham, Ellison has perspective. In the late 1980s, during the Resolution Trust takeover of ailing savings-and-loans, his average purchase price for banks was 45% of book (some went as cheaply as 25%). By 1996, when financials had rallied big-time, the fund he ran at the time (Fidelity Select Home Finance) had one of the best 10-year records in the country, with a 21% annual return.

"If I buy a bank stock today, I want to see it able to go up three- to fourfold to offset the fact that it might still go down 20% to 30%," says Ellison.

As for shareholders, his comments are sobering. "If people have lost money in their 401(k)s, they're not going to get it back unless they save and put new money in. The market's not automatically going to give it back to them."

A U.S. investor owning foreign stock index funds would have made 12.1% last year in France, more than double the S&P 500s 5.5% total return.

But the French performance is deceiving. It reflects the weakness of the dollar, which made investments in euro-denominated securities worth more to U.S. investors. In euros, France was up just 1.2% (dividends included). Canadian stocks did well for Americans last year, up 28.4%. But for Canadians they earned only 10.5%.

Pay attention to currencies when you go shopping for an international fund. The performance number you see may look like evidence of being in the right economy at the right time. On closer examination it may amount to not much more than a currency move.

A bet on foreign stocks is really two bets at once: that equity markets will do well overseas and that the dollar will be weak. You can separate these bets if you want. There are ways, which we will detail below, to buy foreign stocks while stripping out the currency effect.

The main reason for investing abroad is diversification. Since European, Asian and U.S. economies are somewhat detached, you can gain in safety by adding foreign stocks without sacrificing expected return. But there is no comparable gain to be had from diversifying your currency exposure. You should have exposure to Japanese yen, euros and Brazilian reals only if you really want to bet against the dollar.

In recent years antidollar bets paid off. In 2007 the greenback lost 9.6% of its value to the euro, and even more to some other currencies like the real (16.7%) and the Polish zloty (15%).

But beware: What goes down eventually comes back. The European Central Bank, faced with a slowing economy on the Continent, is mulling a reversal of its tightening bias. The Bank of England, the U.K.s central bank, already has loosened. Lower interest rates tend to bring on lower currency values. Purchasing-power comparisons also suggest that euros and pounds are a bit overpriced and due for a correction.

With the worlds largest economy by far, the dollar has enjoyed preeminence over most of the last century. Still, it suffers periodic spells of weakness. Jeremy Grantham, chairman of GMO in Boston, has charted six cycles dating back to 1973. He measures the performance of the S&P against the rest of the developed world, using the EAFE Index, excluding the skewing effect of Japan and its endless economic woes. In all six cycles one index outperformed the other by at least 50 percentage points. In all cases, currency movements have accounted for a significant portion of the winning indexs extra return.

In the latest cycle, December 2001 through year-end 2007, the EAFE went up 152% in dollar terms while the S&P was up only 44%. But the EAFE went up only 57% in local currencies. Six years is a long time, and we may be ready for the next cycle. Should the dollar regain momentum, the currency differential that juiced foreign indexes will work in reverse, and U.S. investors riding high on overseas funds could get hammered.

So how do you diversify into foreign stocks without taking a lot of risk in foreign currencies? Here are some ways.

Buy a hedged fund. The Tweedy, Browne Global Value Fund, which gets a FORBES grade of D in up markets but scores an A in down markets, hedges its foreign currency exposure. That is, if it bought a stock in Brazil it could simultaneously short some reals. The Julius Baer International Equity Fund is another good one (grades: A and A) that does some hedging.

Buy a fund and buy a hedge. Most international funds do not hedge currencies. That group includes such actively managed funds as the Vanguard International Growth Fund (FORBES grades: B and B) and most index funds (that is including exchange-traded funds). If you want to own the stocks in these funds but not their implicit currency bets, buy the fund and then short the corresponding currency.

There are several ways to short currencies. If your stake in one foreign currency is large enough (close to six figures), you could trade currency contracts on the
Chicago Mercantile Exchange
. For example, you could sell a June euro futures contract (youd have to put up a $2,600 margin on a 125,000 euro contract). If the euro goes up 10%, you would be up $18,300; if it goes down 10%, youre out the same amount. This contract would have to be rolled over every quarter otherwise youre on the hook for the full value.

Futures trading is not for the faint of heart, cautions Daniel ONeil, executive vice president of futures at
OptionsXpress
in Chicago. But its a very effective way to hedge against adverse currency fluctuations.

High rollers looking to hedge a fund that has a variety of foreign currencies built into it, such as the iShares MSCI Emerging Markets Index, should consider something like the U.S. Dollar Index on the ICE Futures exchange, which allows investors to play the dollar against a tradeweighted basket of euros, yen, pounds and other currencies. The match between the stock weightings and the currency basket is not perfect, but it is close enough. Go long to protect yourself from a slump in volatile overseas currencies. Current contract size: $76,000.

There are plenty of currency funds that work in the other direction. That is, they are bullish bets on foreign exchange and bearish bets on the dollar. Example: the
CurrencyShares British Pound Sterling Trust
. Could you just short one of these things to hedge away your pound exposure? In principle, yes. But in practice its a bad idea for an individual investor to short stocks for long periods. Reason: Brokers have a habit of cheating retail customers out of the interest earned on the proceeds of short sales.

Buy stocks in countries whose currencies dont move much against the dollar. Here you can get your taste of foreign equities without a lot of currency risk. Look for ETFs that own stocks traded in Shanghai, Hong Kong and Mexico City, since the yuan, the HK dollar and the peso have been relatively steady against the dollar.

One other strategy to consider is this: You take currency risk but take it in a currency you think will appreciate against the dollar. Grantham says that although securities in developing nations look overpriced, they offer relative value. They are growing like weeds, their finances have never been better, theyre acquiring dollars, their currencies are strong and they sell at a discount on P/E, he says. What else do you want?

Perhaps the
iShares MSCI South Korea Index Fund
. This ETF tracks a market that boasts a current price/earnings ratio of only 14, cheaper than the S&Ps 17.

On The Cover/Top Stories

Should You Still Buy Value Stocks?

David Serchuk and James M. Clash 04.09.07

After a seven-year run value stocks are pricier than ever. When Jeremy Grantham says that, it's time to think about buying growth stocks instead.

At the end of the 20th century some starry-eyed investors spied the dawn of a new paradigm. Technology, productivity and the Internet knew no bounds, and so it was impossible to pay too much for a stock like Amazon or
Cisco
. Meanwhile, value stocks--those trading at low multiples of sales or book value--languished.

Today the situation has reversed. Everyone, it seems, is a fan of value. What does that tell you? Probably that you should sell value stocks and buy something else--namely, growth stocks. You pay extra, of course, for companies with better prospects, but not much extra. In today's market, traditional growth companies like
Microsoft
and Johnson & Johnson are comparative bargains.

For evidence that value stocks are overbought we can find no better witness than Jeremy Grantham, a famous fan of the genre. A fan, that is, when value is indeed cheap. But it isn't cheap now, he says. Grantham is the professorial chairman of Boston money management firm GMO. He knows from experience that growth and value spurts tend to run in five- to seven-year cycles, and it is time for a change. "The last time one market segment won this consistently was growth's final run from 1999 into early 2000," he says. "And we don't have to tell you how that party ended."

As a market savant, Grantham, 67, has few peers. A value-oriented fellow who has studied market trends for decades, he called the end of the 1990s tech bubble before it burst, and then he forecast the current heyday of value stocks.

Grantham's firm (assets under management: $141 billion) has a stellar record managing money, mainly for institutions and a few wealthy folks. Grantham is the sole founder still working full-time at the firm, whose acronym stands for Grantham, Mayo, Van Otterloo & Co. Richard Mayo left the firm a few years ago, and Eyk Van Otterloo is still a director.

GMO has a handful of high-performing mutual funds, but with minimum investments of $10 million, they are out of the reach of most. Over the past five years, amid broad popularity of foreign investments, GMO International Intrinsic Value II clocked a 19.5% annual return, beating its benchmark, the MSCI Europe Australasia Far East index, by 4.9 percentage points. Its U.S. Intrinsic Value III portfolio had a respectable five-year annual return of 6.7%.

You have to admire GMO's devotion to the number crunching that is the basis for its successful augury. In 2001 GMO called the market turn by comparing the average price/book ratio of the 125 S&P stocks that had the lowest such ratios with the index as a whole. The historic average ratio for the bottom quartile is just over half that of the whole index. Then as the tech bubble burst, the lowest quartile averaged just one-quarter of it, which looked like a bottoming and heralded a turnaround.

If you'd followed Grantham's advice back in 2001, you'd be content. He saw double-digit growth ahead for small and midsize value stocks, and that is exactly what happened (see chart). In fact, value funds specializing in companies with small (averaging $1.5 billion) market capitalizations returned 13.6% annualized over the past five years, and midcap value reaped 13.4%. Large-cap value didn't do as well as its smaller brethren (8.2%) because it has become a repository for onetime hot-growth companies like
General Electric
and
Pfizer
, which have joined the value ranks as their once towering P/Es shrank.

Over the past five years small and medium-size growth companies returned more like 8% annually. Large-cap growth, by comparison, returned a miserly 3.4% annually during that time.

Grantham uses the same methodology as he did earlier in the decade to conclude that today's value stocks are way overpriced. Take that comparison of average price/book ratios for the cheapest 125 S&P stocks (in price/book) with the average for the index as a whole. Normally the clunker stocks go for 50% of the S&P's price/book; now they're at 65%. What's more, value stocks are not only expensive relative to 2001, they're more expensive than at any time over the past 40 years. "Low price/book stocks don't win by some divine right," says Sam J. Wilderman, a GMO partner. "They win when they are priced to win, and they've never been this rich."

Indeed, small-company value stocks (like
Jos. A. Bank Clothiers
) are riskier than the large company value (like
Altria
) because the small ones tend to have less stable returns and lower profit margins. And, Grantham warns, midcap value names are the riskiest yet. Reason: So many investors took part in the small-stock boom that they've bloated the market value of a lot of smaller firms (small in revenues, employee count and so on) into the midcap range.

Louisiana-Pacific Corp.
might look cheap. By conventional metrics it's a value stock because it goes for 17 times earnings. But its three-year earnings growth is hardly praiseworthy (--20%), and it's trading at the high end of its historical P/E range.

The explanation for the mid- and small-cap craze, says Grantham, is that the business climate of the past few years--featuring high consumption, high global growth in economic output and fat profit margins--has been so strong that it has spilled over to smaller companies. Their suddenly robust financial performance attracts inordinate Wall Street interest, especially for the relatively cheap small stocks. "So their profit margins have gone up more than the Mercks, the Eli Lillys and the General Electrics," he says.

What should an investor do? Search for buys in the lagging large-company growth category (see "The New Value Stocks" table). Stocks like Microsoft and
Dell
look like buys, given their earnings growth and their past p/es.

The two GMO funds cited before stay in large-cap territory, and they weathered the 2000--02 bear market quite nicely; while they lost money in some of those bad years, they beat the market every time. Lately the strategy of GMO's U.S. value fund has been to take advantage of a change in the value game board. It tilts away from value stocks that have become overpriced and favors ones that have fallen from the growth category.

Since few investors can afford a GMO fund, we've collected some alternatives (see "How to Navigate the Coming Value Collapse" table). These five funds, which get mostly good grades from FORBES for their performance in bear markets, charge below the 1.6% yearly average for domestic actively managed funds.

The Yacktman Fund holds some dispirited names that could come back. Returning 12.5% annualized over the past five years, the fund earns just three stars overall from
Morningstar,
although it, too, easily bests the S&P 500. This fund's leading holding is Coca-Cola, making up 9% of its net assets. The soda giant has seen some hard times recently; its $48 share price is $10 less than in late 1999. The P/E has also slumped: 22 compared with 59 during the bubble. Sounds like a buy. In addition, the fund holds once lofty Microsoft.

Now let's take a look at the overheated value stocks, whose current market runs, if Grantham is right, represent a value peak. In 1999
Boeing
, Federated Department Stores and
Harrah's Entertainment
were genuine value stocks, with price/earnings ratios half the market's 30. Now they are all trading at P/Es above the market's average P/E of 17. For the moment their prospects look good. Boeing is enjoying a surge in airplane orders, Federated a revival at
Macy's
, Harrah's a boom in casino traffic.